The Risk of Option ARMs

Holden Lewis at Bankrate.com wrote an article of this same title many weeks ago and I thought it was timely in that he was warning us of the impending problems we’re now facing today.

In many ways it’s still worth the time to read it and even though this kind of loan may not be available or as interesting as it once may have seemed, some of those borrowers temped to utilize such a product won’t even be a legitimate buyer these days. It could still be “The Right Time To Buy” Boulder real estate but another loan product may be your destiny. Presented for your consideration and comment is his original article…
A mortgage called the option ARM offers a tantalizing possibility: payments that are so low, you can owe more on the house at the end of the month than at the beginning.
Option adjustable-rate mortgages are appropriate for some borrowers in certain circumstances, and they’re dangerous for other people because of the danger of falling too far into debt. A recent cover story in BusinessWeek dubbed the option ARMs “nightmare mortgages” and called them “toxic” and “deceptive.”
If you have an option ARM, here are five warning signs that you are assuming a lot of risk.
_ One: You don’t understand how an option ARM works, but you have one anyway.
An option ARM is an adjustable-rate mortgage that gives the borrower four choices of a payment each month. The borrower can pay the amount necessary to pay the loan off in 15 years or in 30 years. The borrower can pay only the interest charged in the previous month. Or the borrower can make a minimum payment that doesn’t even cover the interest, so that the loan balance increases.
Most option ARMs have absurdly low introductory rates, sometimes below 2 percent, that last just a month. Then they rise. And rise. The rate changes each month, but the minimum required monthly payment changes only once a year.
“The thing no one realizes is the rate is fixed for only 30 days,” says Mitch Ohlbaum, president of Legend Mortgage in Los Angeles. “The payment is fixed, and that’s nice _ but the rate isn’t.”
As the introductory interest rate doubles, then triples, then quadruples and even quintuples, the minimum payment rises a maximum of 7.5 percent a year. Some borrowers may find that, when they make the minimum payment, their loan balance increases more than $1,000 each month.
_ Two: You exaggerated your income on your application. A lot of option-ARM borrowers have stated-income loans, in which the lender doesn’t verify the amount that the borrower claims to earn. If you puffed up your income, you are more likely to default.
_ Three: You regularly have been making minimum payments _ not paying down your debt and, in fact, increasing it. You feel this not only in your pocketbook, but in your gut.
“It’s a monthly toll,” says Bob Moulton, president of Americana Mortgage, a brokerage on Long Island, N.Y. He sees option-ARM borrowers “angsting over this change happening each month” and wondering where it will lead.
_ Four: You’re approaching the principal cap.
When you make the minimum payment, and the loan balance increases, that phenomenon is called “negative amortization.”
Lenders set limits on how far negative amortization can go. Most option ARMs have a principal cap of 110 percent, meaning that if your loan balance reaches 110 percent of the initial loan amount, you’ll suddenly have to start paying down the loan balance.
Before you reach the principal cap, the minimum monthly payment can rise only a maximum of 7.5 percent a year. After you reach the principal cap, that limitation is thrown out the window. The minimum monthly payment can more than double in some cases.
_ Five: House prices in your neighborhood are falling.
The danger with falling houses prices is that you could end up owing more than the house is worth. That puts you in a position where you can’t afford to refinance the mortgage or sell the house unless you have enough cash lying around to make up the difference. And if you have that much cash, why are you in over your head with your mortgage?
“Basically, what you’re going to have on a lot of those pay option ARMs is you’re going to see a lot of customers giving the keys back,” says Mark Lefanowicz, president of E-Loan.
To stay out of trouble, there are a number of things you can do if you have an option ARM: Make at least the interest-only payment, refinance the loan or sell the house and pay off the mortgage.
By making the interest-only payment, you’re at least treading water instead of sinking under the waves. You’re not paying down principal but you’re not adding to it, either.
But if you can’t handle interest-only payments, it’s time for plan B: refinancing the loan. Talk to your current loan servicer to find out if there’s a prepayment penalty and how much it would cost.
Then there’s plan C. That’s when you recognize that you bought more house than you can afford. The solution: Sell it.

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